TEAMFLY

to Mutual Funds

Morningstar
®
Guide
to Mutual Funds
5-Star Strategies for Success
Christine Benz
Peter Di Teresa
Russel Kinnel
John Wiley & Sons, Inc.
Copyright ©  by Morningstar, Inc. All rights reserved.
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but an introduction had been made. Over time, I read more about
investing and particularly about mutual funds. I paid special attention to Sir
 
John Templeton’s advice, reading his annual reports and watching him on his
visits to
Wall $treet Week
with Louis Rukeyser. In short, I had started down
the path to becoming an investor.
Over time, I’ve realized that the real lesson from those first few shares of
Templeton Growth wasn’t how a mutual fund works, but how a responsible
adult acts. In effect, my Dad was showing me that investing was something
he did to help provide for our family. He wasn’t jumping in and out of hot
stocks. He was systematically setting a little bit aside each month to build for
a better future, and he wanted me to know that I could do the same. He
taught me that investing, by its very nature, is a responsible act. It’s deferring
the instant gratification of consuming today in hopes of providing a more se-
cure future for yourself and for your loved ones. How different that message
was from the messages on television (save those of Rukeyser’s show) that por-
trayed investing as something only for the snobbish elite. The same shows
that disparaged investing were supported by countless commercials touting
the immediate satisfaction to be derived from spending!
Fortunately, our collective attitude toward investing has improved since
the days when J. R. Ewing was the only one on television you saw making in-
vestments—and doing so to hurt people, I might add! The rise of personal fi-
nancial journalism, led by
Money
magazine, has opened up investing to a
much wider audience. There’s never been a time when an individual investor
had as many resources at his or her disposal as today. If anything, the chal-
lenge has shifted from finding information to making sense of an overload of

late to the game in the s, but plunged in anyway, later turned their backs
on stocks at much more attractive prices. Clearly, the path to investment suc-
cess requires a discipline that’s easier to grasp than to master.
Fortunately, you don’t have to go it alone. I learned much about patience
and the benefits of weathering bad markets through the lessons of owning the
Templeton fund. I’ve learned even more by working at Morningstar
®
with a
group of people who genuinely like investing and want to learn more. Having
smart people to share ideas with is a great benefit during tough markets. Sadly,
many investors have no choice but to go it alone, having few friends or col-
leagues with whom they feel comfortable discussing their finances. That was
certainly the case for me prior to joining Morningstar. I didn’t find a lot of fel-
low investors in high school or even in college. I remember long nights in
graduate school poring over personal finance magazines trying to make sense
of the bewildering world of mutual funds to begin to put together a financial
plan for my family. What a joy to join a community of fellow investors.
Now that opportunity is open to everyone.
The Morningstar Guide to Mu-
tual Funds
is an invitation for you to join a community of investors who want
to better understand what makes funds tick and what separates the top man-
agers from the rest of the pack. You’ll learn from three fine teachers—Chris
tine
 
Benz, Peter Di Teresa, and Russ Kinnel—each of whom not only offers great
insights on funds, but also has a real talent for making investing accessible and
fun. You’ll learn the lessons we’ve found most valuable over the years—every-
thing from how to read fund documents to assembling a well-balanced port-
folio. In short, you’ll get the “on-ramp” introduction you need to get moving

Susan Dziubinski’s tremendous work in educating investors. Senior analysts
Bridget Hughes and Eric Jacobson provided valuable edits. David Pugh, our
editor at John Wiley & Sons, gave us vital guidance for completing the book.
Not only did Don Phillips write the foreword, as Morningstar’s first analyst,
he has set high standards for all of us who have come after him.
Morningstar fosters collaborative efforts, and it’s fair to say that the hun-
dreds of people who work here deserve a share of the credit for this book. Most
important, founder Joe Mansueto set the spirit for Morningstar and for this
book by promoting independent, objective analysis that puts investors first.
TEAMFLY
Team-Fly
®

Contents
 :     
Chapter : Know What Your Fund Owns 
Using the Morningstar Style Box

Using the Morningstar Categories

Examining Sector Weightings

Examining Number of Holdings

Checking Up on the Frequency of Portfolio Changes

Investor’s Checklist: Know What Your Fund Owns

Chapter : Put Performance in Perspective 
Understanding Total Return

Checking Up on Aftertax Returns

Putting Returns in Perspective

Using Indexes as Benchmarks


Avoiding the Rearview Mirror Trap

Understanding Sales Charges

Investor’s Checklist: Keep a Lid on Costs

 :     
Chapter : Match Your Portfolio to Your Goals 
Defining Your Goals

Setting Your Asset Allocation

Targeting Your Goal

Making Up for Shortfalls

Diversifying Your Portfolio

 
Investing for Goals That Are Close at Hand

Investor’s Checklist: Match Your Portfolio to Your Goals

Chapter : Put Your Portfolio Plan in Action 
Building Your Portfolio’s Foundation

Knowing How Many Funds Are Enough

What You Really Need: Diversification



Investor’s Checklist: Move Beyond the Core

Chapter : Find the Right Bond Fund for You 
Understanding Interest-Rate Risk

 
Understanding Credit-Quality Risk

Buying Core Bond Funds

Specialty Strategy 1: Municipal Bond Funds

Specialty Strategy 2: High-Yield Bond Funds

Specialty Strategy 3: Prime-Rate Funds

Specialty Strategy 4: Inflation-Indexed Bond Funds

Putting It All Together

Investor’s Checklist: Find the Right Bond for You

Chapter : Finding the Right Fund Companies for You 
Kicking the Tires: No-Load Fund Families

Kicking the Tires: Load Fund Families

Kicking the Tires: Boutiques



Plan for Taxes

Rebalance

Investing in Bull Markets

Investor’s Checklist: Keep a Cool Head in Turbulent Markets

 :    :
 
Chapter : Look Inside Morningstar’s Portfolios 
Using the Portfolios

Our Fund-Selection Process

Putting the Pieces Together

 :    : 
 
. How Does the Morningstar Rating for Mutual
Funds Work? 
. What Should I Do When My Fund Loses a Star? 
. How Does Morningstar’s Style Box Work? 
. How Do I Buy My First Fund? 
. What Should I Do When My Fund Manager Leaves? 
. Should I Buy a Rookie Fund? 
. Should I Buy a Fund That’s Closing? 
. Should I Buy a Fund That’s Doing Really Well? 
. Should I Buy a Fund That’s in the Dumps? 

high-profile fund managers are buying is a constant source of e-mail chatter
in the office. Our analysts examine fund portfolios of holdings, talk with
the managers about their strategies in picking those holdings, and check
on recent changes to the lineup. Knowing what a fund owns helps you un-
derstand its past behavior, set realistic expectations for what it might
do in the future, and figure out how it will work with the other funds
you own.
     
At the most basic level, a fund can own stocks, bonds, cash, or a combi-
nation of the three. If it invests in stocks, it could focus on U.S. companies
or venture abroad. If the fund owns U.S. companies, it might invest in
giants such as General Electric or Microsoft or seek out tiny companies that
most of us have never heard of. A manager may focus on fast-growing com-
panies that command high prices or on slow-growth (or no-growth) firms
trading at barg
ain-basement prices. Finally, managers can own anywhere
from  to hundreds of stocks. How a manager chooses to invest your money
has a big impact on performance. For example, if your manager devotes
much of the portfolio to a single volatile area such as technology stocks, your
fund may generate high returns at times but will also be very risky.
A fund’s name doesn’t always reveal what a fund owns because funds
often have generic handles. Take the intriguingly named State Street Research
Aurora and American Century Veedot funds. If you were to skim over only
their names, you would be hard-pressed to glean that the former focuses on
small companies that are trading cheaply, whereas the latter is a go-anywhere
fund that uses computer models to help direct investments. Nor do the ob-
jectives that the firm identifies in its prospectus always give you clues about
its portfolio. Aegis Value Fund focuses on tiny, budget-priced stocks, whereas
Alliance Premier Growth focuses on fast-growing stocks of large companies.
The Aegis fund returned % in , whereas the Alliance fund lost %


biotech firm Amgen). We score each stock in several ways ranging from value
Figure 1.1 The Morningstar style box is a nine-square grid that provides a quick and clear picture
of a fund’s investment style.
Level of Investment Style
Risk Value Blend Growth
Low
Moderate
High
Median Market
Capitalization
Large
Medium
Small
Large-Cap
Value
Large-Cap
Blend
Large-Cap
Growth
Mid-Cap
Value
Mid-Cap
Blend
Mid-Cap
Growth
Small-Cap
Value
Small-Cap
Blend
Small-Cap

could be too high across the board, value funds’ budget-priced stocks don’t
have very far to fall.
Funds that hit the small-growth square of the style box are usually the
riskiest. The success of a single product can make or break a small company,
and because small-growth stocks often trade at lofty prices, they can take a
disastrous tumble if one of the company’s products or services fails to take off
as the market expects. These funds can deliver glittering riches in upmarkets,
     
though: In , the average small-growth fund returned % (for more on
the correlation between investment style and risk, see Chapter ).
Using the Morningstar Categories
Despite the usefulness of the Morningstar style box, it’s just a snapshot of the
fund’s most recent portfolio. When you are selecting a fund to play a partic-
ular role, such as adding large-cap value stocks to your portfolio, you want to
be confident that it actually has played that role over time. That’s what we
have in mind when we plug funds into Morningstar categories. We assign
funds to categories based on the past three years’ worth of style boxes. A sin-
gle portfolio could reflect a temporary aberration—maybe the fund’s hold-
ings have been doing really well, so they have grown from small- to mid-cap
as stock prices have gone up. But because a fund’s category assignment is
based on three years’ worth of portfolios, it gives you a better handle on how
the fund typically invests.
Our categories are based on the style box with style-specific categories
ranging from large value in the upper left corner to small growth in the lower
right corner. We also carve out some categories for specialized funds. To name
a few, there are categories for high-yield bond funds, Japan funds, and health
care funds. Morningstar slots funds into about  categories (see Figure .).
As with the style box, Morningstar categories pick up where fund names
and prospectus objectives leave off. They help you figure out how a fund ac-
tually invests, which in turn lets you know how to use it in your portfolio. If

Financial
Health
Natural Resources
Precious Metals
Real Estate
Technology
Utilities
Hybrid Conservative Allocation
Moderate Allocation
Bear
Specialty Bond High-Yield Bond
Multisector Bond
International Bond
Emerging Markets Bond
Bank Loan
General Bond Long-Term Bond
Intermediate-Term Bond
Short-Term Bond
Ultrashort Bond
Government Bond Long-Term Government
Intermediate-Term Gov’t
Short-Term Government
Municipal Bond Muni National Long
Muni National Intermediate
Muni NY Long
Muni NY Intermediate
Muni CA Long
Muni CA Intermediate
Muni Florida
Muni Pennsylvania